The Family Investment Company - An Integrated Income and Estate Tax Planning Tool

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Overview

As we approach the edge of the fiscal cliff over the last two weeks of 2012, some of you may be wondering if there is any last minute tax planning that might be done to avoid sending a large check to Uncle Sam next April or alternatively, to receive a bonus (refund) from Uncle Sam.

This article is designed to provide an overview of a technique that might allow you to accomplish this objective. I have a good friend and colleague that works for a large charitable foundation that has grown tremendously in thee tough economic times by focusing its efforts on planning for the “high hanging” fruit instead of cash, the “low hanging” fruit. The foundation has focused on planning for in kind gifts such as gifts of an interest in a closely held business or limited partnership interest in a real estate investment. This planning is an extension of that planning.

The reality of the planning using the Family Investment Company, LLC  is that it is the  same “family limited partnership” or “family limited liability company” used in asset protection and estate planning with tax valuation discounts is the same foundational piece for exceptional tax planning.

Strategy Overview

The strategy focuses on the idea of donating membership units in a family investment LLC to a donor advised fund or a public charity. The Internal Revenue Code allows for a variety of deductions for charitable contributions.

In the typical and simple charitable encounter, the taxpayer gives cash or property to a charity and that is the end of the transaction. The charitable gift is irrevocable and the taxpayer parts with dominion and control over the property. The charity has the cash or property for use in its charitable purposes and the taxpayer receives a tax deduction for the contribution.

LLCs are taxed as partnerships for federal tax purposes. Partnerships are not eligible to take deductions at the partnership and as a result deductions are reflected at the level of the partner or member in the case of an LLC. An individual taxpayer’s charitable contribution is limited to a percentage threshold of adjusted gross income.

Certain public charities are eligible for a charitable deduction up to 50 percent of AGI. These public charities include churches, community foundations, educational organizations, foundations for the benefit of colleges, hospitals and other publicly supported organizations Under IRC Section 170(b)(1), an individual may take a deduction up to 50 percent of his AGI to these charities. The 50 percent ceiling only applies to contributions of cash.

Ordinary income and short term capital gain property are subject to the 50 percent threshold if the charitable gift is made to a public charity. The deduction for short term capital gains is limited to the property’s basis. As a result, the gift of a Charitable LLC interest that is still within the holding period for long- term capital gains treatment would be eligible for the 50 percent of AGI threshold.

If the charitable contribution is in the form of property which if sold would result in a long term capital gain, the deduction for that item may not exceed 30 percent of the taxpayer’s AGI. The family investment company provides for a charitable contribution limited to 50 percent of AGI based on the fact that the LLC is capitalized in 2012, and the charitable donation is made in 2012 as short-term capital gain property. Excess contributions may be carried forward for the next five tax years.

The taxpayer must obtain a valuation of the LLC interest donated to the charity. The cost of such a valuation ranges from $3,500-5,000. The valuation can be completed in 2013 before the taxpayer files his tax return in April. The appraiser considers a number of factors in determining a valuation including the underlying assets of the LLC as well as the LLC operating agreement focusing on the degree of control of the managing member. The valuation will most likely reflect a small discount in the valuation of the LLC interest for lack of marketability.

This discount reflects the fact that the LLC interest is not readily marketable like a public security. The second discount is for lack of control as the LLC interest gifted to a charity will not possess any of the management control of the LLC’s managing member. Depending upon the underlying assets of the LLC, the discounts can range from 10-30 percent. It is my expectation for an LLC funded with cash and marketable securities to have an LLC valuation discount of 15-20 percent.

IRS compliance requirements require a valuation of a charitable donation in excess of $5,000.The appraiser of the LLC interest and charity sign Form 8283 reporting the gift. The charitable contribution is reported on Line 17 of Schedule A of Form 1040. The charitable contribution is not a preference item in the calculation of the alternative minimum tax.

From an estate and gift tax perspective, the Family Investment Company LLC is a powerful planning tool. Gifts to a public charity are eligible for a charitable gift tax deduction. As a result, the gifted LLC interest would not be included in the taxpayer’s taxable estate .

The Family Investment Company LLC is a simple but elegant philanthropic solution that adequately addresses another of the traditional problems of charitable gifts – (1) Loss of control over the money (2) Loss of control over the disposition of the money (3) Loss of investment control (4) Loss of access to use of the funds for financial planning purposes. The Charitable LLC (properly managed) is able to overcome these problems in a conservative manner from a tax perspective.

It goes without saying that the Family Investment Company also accomplishes the same objectives it always did absent the charitable inclination of a taxpayer’s planning – (1) Centralized management and control over family investment assets. (2) Asset Protection (3) Income Splitting (4) Estate reduction

I recommend the creation of a Delaware or Nevada LLC for use as a Charitable LLC. Delaware has many advantages including charging order protection from creditors of the LLC. The charging order is the exclusive remedy for a creditor of the LLC or its members in those states.

A charging order is a judicial lien that a creditor lien may obtain against the LLC and its members. Importantly, it does not allow the creditor to take control over the management and assets of the LLC.

The creditor has no legal authority to force a distribution of LLC income and assets. As a result, charging order protection for LLCs offers strong asset protection for the LLC and its members. As your donor advised fund will own up to 99 percent of the LLC interests, the structure will not be subject to the claims of your personal creditors.

The Family Investment Company LLC is a valid company for all practical purposes. Under state business and federal tax law, investment management constitutes a valid business purpose. Aside from its business purpose, the LLC is similar to any other closely held business. The Family Investment Company, LLC allows the taxpayer  to retain management control over the LLC and its assets. The Managing Member pursuant to his powers under the operating agreement would also retain full control over distributions to the public charity.

As Managing Member, the taxpayer is able to retain an income interest from the LLC. The compensation should be arms-length in amount and structure. Investment partnerships (private equity and hedge funds) frequently provide an investment structure that has a management fee of 2-3 percent as well as a performance fee equal to 20-30 percent of investment income within the LLC. This management fee could also be deferred on an indefinite basis.

The operating agreement of the LLC has typical powers for the managing member. The operating agreement allows the managing member to make loans using LLC assets to himself or other members of the LLC, or to secure a loan on behalf of the LLC. The terms of the loan should be arms-length equal to the Applicable Federal Rate (AFR).LLC funds could be accessed through the LLC using tax-free secured or unsecured demand loans.

The public charities that receive benefits under the taxpayer’s Donor Advised Fund, will receive a large endowment equal to its LLC interest, once the LLC is liquidated which may be multiple generations. The LLC operating agreement may provide for a finite period of existence, i.e. 40 years or perpetual existence subject to the decision of the managing member. The managing member interest may be gifted directly or in trust for future generations in order to perpetuate the structure. Life insurance in an irrevocable life insurance trust insuring family members may be used to replace wealth that passes to the donor advised fund.

The legal viability of the Family Investment Company from a tax standpoint with respect to charitable deductions is dependent upon treating the charities fairly. The taxpayer should establish a regular pattern of distributions as managing member for the benefit of the Donor Advised Fund. No legal standard exists to establish how much is too little or too much. As a result, I recommend annual distributions to the Donor Advised Fund of at least 2-5 percent of the LLC’s net asset value.

A Donor Advised Fund is a form of community foundation. The Donor Advised Fund is a separately identified fund or account that is maintained and operated by an IRC Sec 501(c)(3), e.g. public charity organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors. Once the donor makes the contribution, the organization has legal control over it. However, the donor, or the donor's representative, retains advisory privileges with respect to the distribution of funds and the investment of assets in the account.

In the case of the Family Investment Company, LLC, actual management control is still legally retained by the LLC’s managing member over the LLC and its assets. The Donor Advised Fund is a more flexible charitable arrangement than a private foundation which has a significantly lower threshold for deduction purposes and is subject to the prohibited transaction rules. The prohibited transaction rules have a number of transactions with a disqualified person under these rules for self-dealing. The Family Investment Company LLC format  avoids these rules.

The grant-making authority of the taxpayer’s family can extend beyond your lifetime and you can change charities frequently. The taxpayer  may also contribute to foreign charities through the Donor Advised Fund.

Summary

The Family Investment Company, LLC is a useful tool for multiple reasons- (1) Asset Protection (2) Management and Control and  (3) Estate Reduction. Last but not least, as you look over the edge of the cliff, the Family Investment Company LLC can provide valuable income tax savings regardless of whether you are a business owner or an investment banker with W2 income.